September 2, 2015

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September 2, 2015

When is a loan modification that reduces the borrower’s interest rate fraudulent and not “benevolent” under the UCC? Maybe when the lender extends the loan repayment period or procures a guaranty from HUD, according to one federal district court.

A husband and wife took out a mortgage. After their divorce, the ex-wife agreed with the lender to modify the mortgage to lower the interest rate by 2%, allegedly without the knowledge or consent of her ex-husband. The lender considered the husband obligated to make the modified mortgage payments and reported him to credit reporting agencies when payments were missed.

The ex-husband brought claims against the bank for breach of contract, violation of the Fair Credit and Reporting Act and defamation. He asserted he was discharged from the mortgage due to the loan modification.

The lender moved to dismiss the case at the outset by arguing that as a matter of law the refinancing was not a material alteration of the loan agreement and therefore the credit report was accurate. The district court denied the motion, thus allowing all the claims to proceed to discovery and a future factual resolution, based in large part on its interpretation of UCC § 3-407.

UCC § 3-407 provides that an alteration fraudulently made discharges the obligation of a non-consenting party. A comment to the section notes: “There is no discharge … if a change is made with a benevolent motive such as a desire to give the obligor the benefit of a lower interest rate. Changes favorable to the obligor are unlikely to be made with any fraudulent intent, but if such intent is found the alteration may operate a discharge.”

The district court held that a jury might reasonably conclude that the modification was not made with benevolent intent, despite the interest rate reduction, because the lender obtained benefits, including an extended loan repayment period and a guaranty by HUD. The court further reasoned that a formal loan modification would have been unnecessary if the alteration “had been immaterial or were simply a benevolent, unilateral interest rate reduction like that mentioned in UCC comment 1 to § 3-407.”

Does this seem reasonable? The interest rate reduction allows the borrowers to reduce the total amount of their interest payments, even if the payment period is extended, because (absent a prepayment penalty) the borrowers may, if able, pay down the loan as if it had never been extended. The HUD guaranty certainly does not harm the borrowers. Indeed, the HUD guaranty indirectly benefits the borrowers, because it reduces the risk of the modification to the lender and thus facilitates the modification that reduces the borrowers’ interest rate. So how could a jury reasonably find the interest rate reduction and the HUD guaranty to be fraudulent?

Yes, “benevolent” does mean “charitable” or “kindly.” However, it seems implausible that the UCC comment is intended to mean that any modification that falls short of being completely charitable can be found fraudulent. Notably, the District Court did not cite a single federal case to support its ruling. Its opinion is troubling because it seems to hold lenders to an eleemosynary standard of intent, rather than a commercial standard of materiality.

What is a lender to do if an ex-spouse refuses to sign a loan modification? First, to avoid potential claims of a violation of the Fair Credit and Reporting Act and of defamation, a lender should not report that the recalcitrant spouse has defaulted after modification; suppress the reporting. Second, consider making a unilateral rate reduction, without requiring a signed modification agreement. Third, if an extension is required, unilaterally waive any prepayment penalty.